The resurgence of Keynesian economic theory

In the tumultuous global macroeconomic climate, which we find ourselves in today, people are increasingly looking back in time at the ideas of one revolutionary economist: John Maynard Keynes. The cogitation of the most influential economist of the 20th century has been thrown somewhat under the water in recent decades, in wake of the 1973 oil shock and the recession that shook much of the developing world from then until 1975. However, contemporaneously with the great recession of 2008, Keynesianism has seen a resurgence, often cited by many scholars nowadays in economic debate. Regardless, even given this, the question remains: is Keynesian economic theory still relevant in today’s day and age? To answer this, we first need to gain a basic grounding in what Keynesianism actually entails. Simply, Keynesianism dictates that increased government spending, combined with lower levels of taxation, can pull a country out of an economic depression. In other words, Keynes proclaimed that a country’s economic output, in real terms, is largely a result of the levels of aggregate demand (the total demand for final goods and services in an economy at a given time). The laissez-faire free market will not automatically lead to full employment, and needs some stimulus, in the form of government intervention through public policy.

Since the macroeconomic revolution that Keynes himself was at the forefront of, the 1970s stagflation (a combination of high inflation and slow economic growth) led to a decline in popularity for Keynes’ proposed policies. However, it is indubitable, especially in the wake of the most recent severe economic downturn, that Keynesianism still has a place in modern economic thought, and may in fact be one of the only solutions to the impending economic depression that the world is heading for. Before Keynes, the widespread belief held was that if consumer demand fell, then prices would fall in turn, therefore leading again to an increase in aggregate demand. However, Keynes disproved this baseless faith in the powers of the free market to rebalance the economy. If governments of countries in the developed world chose to do nothing, in the hope that their economy would have somehow “fixed itself”, they might have ended up in economic quicksand synonymous with that of Japan’s since their economic boom ended in 1990. After the great 2008 recession, Great Britain’s chancellor, Alistair Darling, announced a massive fiscal stimulus package for the country, which was then, in turn, announced by China to the tune of around $586 billion, among others. The famous quote from Milton Friedman in 1965, namely that “we’re all Keynesians now”, could never be truer than in 2008. Ed Balls later described this stimulus package as “a classic Keynesian response”, indicative of how far support for Keynesian economic policies had come.

The Keynesian thought that many policymakers had incorporated is not the only mark that the famous economist’s thoughts have left in recent years. One of the major causes of the 2008 recession being so brutal was Keynes’ own “paradox of thrift”. In a nutshell, this states that people will try to save more money during a recession, thereby leading to a decline in consumer spending, ergo a decline in aggregate demand and also economic growth. In September 2009, the US’ value for consumer spending was at 85, which was 5% lower than the trend since December 2007 would have indicated, according to the New York Times. When businesses see demand reducing for their goods and services, they may also think twice about reinvesting their money in alternative ventures, thereby completing the negative cycle. Consumer demand plummeted during some months of 2008, which led to a gargantuan decline in some integral sectors to the economy, for example manufacturing. The paradox of thrift was a major reason why 2008 was the worst recession since the recession that Keynes actually modeled his ideas for. Therefore, it is only logical to assume that in future, utilising Keynesian thought, we can anticipate the impending paradox of thrift and take policy measures to act against it.

Keynes also promulgated the term “liquidity trap”, which essentially means that consumer demand for liquid assets (assets that can be converted into cash in a short time, with little or no loss in value) is greater than inflation (a general increase in prices and fall in the purchasing value of money). Therefore, as the average Joe prefers cash to liquid assets, governmental attempts to persuade people to buy illiquid assets would fail, as people prefer cash to those assets. Therefore, the effect of increasing the supply of money (i.e. lowering interest rates) would be minimal. Several decades after Keynes’ own death, his ideas again became reality in the UK in the years following 2008. In March of 2009, interest rates were cut to 0.5% in an attempt to revitalize a battered and bruised economy. However, following a feeble recovery in 2010, the economy began to sink again in 2011 and 2012, with it shrinking by 0.3% in the last quarter of 2012. This is one of the greatest examples of a liquidity trap in recent years, with the aforementioned trap meaning that the UK economy remained on its knees in the years following 2008. Again, in times of economic downturn, Keynes’ ideas became more relevant than ever.

“Marginal propensity to consume” is also one of the ideas that Keynes is most famous for. Simply, marginal propensity to consume is the concept that with an increase in disposable income, people will have more money with which to consume goods and services. According to the formula that the multiplier effect equals 1/(1-mpc), where “mpc” is the marginal propensity to consume, an incremental increase in consumption will lead to a large multiplier effect in the economy. Now, this idea can be applied to one of the banes of society: income inequality. As people of lower income levels have a higher marginal propensity to consume (i.e. they can buy more goods as opposed to the rich, who do not have many goods to buy as they already possess them), it is only logical that an increase in their income will lead to a higher total marginal propensity to consume, and therefore a far larger multiplier effect. Now, in countries such as America, where the top 0.1% have 184 times more average income than the bottom 90%, it is fair to think that, if they could somehow reduce this gap between the rich and the poor, they could see ferocious levels of economic growth. In a nutshell, Keynesian theory means that increasing levels of economic growth will be synonymous with lowered levels of income inequality. This is the reason why Scandinavian countries with low levels of income inequality, such as Sweden, are seen as some of the most prosperous on earth.

In summary, although many austerians and monetarists would love to believe that Keynesianism is dead, the reality is much the opposite. With the turbulent economic conditions that the world is facing even today, Keynesian thought will only see increased popularity, as more and more people will see that an increase in aggregate demand is a logical way to spur economic growth. Through the times of economic hardship in recent years, several Keynesian theories, including the liquidity trap and the marginal propensity to consume, among others, have become readily apparent in modern society. It’s fascinating to think that someone who died 70 years ago could have such an impact on the macroeconomic sphere of today. While these theories will still be modified and readjusted to fit the modern age, one thing is certain: Keynesian thought isn’t going anywhere anytime soon.

26 Comments Add yours

  1. moslerfan says:

    Nice comments, Shrey. I took an online macroeeconomics class where the professor stated bluntly that ’70s stagflation proved Keynes wrong, because he had said that simultaneous inflation and unemployment was not possible. But Keynes was talking about his own time (Depression). If he had been asked in 1970 what would happen if the price of the most important industrial commodity rose 10x (from about $3.50/bbl to $35/bbl) he would have pointed out that the costs would be passed on to prices (inflation) and then, as certain occupations became unprofitable due to price increases, unemployment.

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    1. I agree completely; many critics of Keynes are very keen to poke holes in his theories, but forget that they were made for another time and obviously need readjustment for today’s time.

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  2. Ryan says:

    Great article, Shrey! I am sort of an agnostic on Keynes. I think he was the most important economic thinker of the 20th Century, no doubt. And I think he had very keen insights into how an economy functions (and functions well). But I don’t know how relevant his policy prescriptions actually are to political reality, at least here in the states. In theory, it is necessary to pair deficit spending with surplus saving, as Keynes prescribes. It is the only way Keynesian economics works long-term. The problem is that everyone wants to spend when times are bad… and when times are good. It is politically unfeasible to run perpetual surpluses in Bull markets. We did it for a short time during the Clinton years, but in the end, as I think will always happen, people would rather keep their own money (i.e. the Bush tax cuts) than pay to offset the deficit spending of the past or the future. It’s obviously more complicated than that, but I think of Keynesian economic theory as I do any other cogent economic theory: it works great except when it really counts. And the dismal science rolls on.

    If you haven’t read Beinhocker’s “The Origin of Wealth,” I would highly recommend it. Also Jane Jacobs’ “Economy of Cities” and “Cities and the Wealth of Nations.” All three books are relative obscure and would get you lynched at the University of Chicago, but they have given me a different perspective on economics. Keep learning and searching, Shrey. You are young and unattached enough that you can get away with not binding yourself to one orthodoxy or another. Please expose yourself to as many heretical ideas as possible and then spend time seriously poking holes in all of them. I promise you’ll be better off for it.

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    1. Thanks 🙂 I’ll definitely check out the books you’ve read. Thanks again for the large comment 🙂

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  3. I can’t argue that Keynesian is alive and well,I can only argue that it is anathema to capitalism and freedom because it relies on central banks manipulating fiat currencies. In other words, theft of value. Note that so-called quantitative easing in the US did not generate the hoped-for increase in consumer demand; most of it went into the big investment banks (the same ones that had just failed) and from there into the stock market. It could have just as easily been doled out as a tax credit or a tax holiday. THAT would have stimulated consumer spending, but it would still have been wrong. Keynesian stimulus from the central bank of a country trillions of dollars in debt is akin to bleeding out from horrific injuries and not stopping the bleeding – while receiving a blood transfusion in your left arm from a tube hooked into your right arm!

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    1. Of course, the theory will need some modifications, however I really do believe that Keynesian theory is alive and well, in moderation.

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      1. It is alive and well, and it certainly causes effects, but it is arrogant and immoral. How would you moderate the immorality?

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      2. Thanks for the comment 🙂 How would it be immoral, however?

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    2. jerhail says:

      le sigh

      Monetary Policy deals with regulating interest rates, particularly of interest is your phrasing capitalism and freedom which is the title of renowned monetarist Milton Friedman.

      US deficit spending is on average about 3% per year leading to higher federal debt. The federal government has run a deficit for 45 of the last 50 years.

      To maximize utility of you blood transfusion example I will suggest it being applied to the prevailing notion that protectionist policy with regard to trade is the solution to our bleeding. Rather we should be removing barriers to trade allowing for more stable international conditions which offer for a leveling of economic inequalities initially within each participant nation and then comparative to the joined nations.

      There is a clear trade off of jobs for political leadership though this is short term. Inevitably the leadership position (used wisely) can promote international policy which will lead to greater gains and political authority. Those nations who gave up political power to gain jobs, in time will see their political authority increase as the entire trade groups authority increases.

      I realize the second half deviated from your argument though I felt it appropriate to capitalize on your excellent transfusion analogy.

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      1. John Moser says:

        It’s not an increase in debt if inflation leads to a reduction in the buying power of that money. That is to say: If the government has $1 trillion in debt, takes on $3 billion more over the next year, and ends the year with enough inflation that $1.003 trillion of +1AD USD is worth $0.998 trillion of +0AD USD, it’s lowered its debt.

        Liked by 1 person

      2. jerhail says:

        I don’t disagree though that sounds like investing in gov bonds $50 for $60 but when you get the $60 it’s actually worth $49.

        That’s just poaching the public purse. And if it’s foreign owed I doubt they would allow exchange fluctuation, I’m pretty sure they would require a value match.

        Unless I’m mistaken this is part of the fuss about money manipulation.

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      3. John Moser says:

        Yes, that’s true. It’s not entirely controllable and it’s essentially risk; and $60 in the future is still worth $50 in the future, so it’s not like it’s the worst risk possible.

        Money systems are complex in part because any reduction of scarcity or changing of real labor costs (reduction of labor-hours required to make a thing) changes the buying power of money in a non-uniform way.

        Population growth also means you get richer with a reduced share of all wealth.

        Say you double productivity, so everything costs half as much; so to avoid deflation, you would double the amount of money. Instead of $100, you’d have $200, and everyone is able to buy the same stuff for the same money, but they also have another pile of money. Everyone can get twice as much stuff!

        Except there are more people because food doesn’t suddenly get 3x as expensive when we try to make 1.5x as much of it. Food now only gets 1.5x as expensive when we try to make 1.5x as much of it because we found a way to make more food on the same amount of land. That means we also expend less labor per unit of food produced, so food is cheap *and* plentiful.

        Instead of everyone getting twice as much stuff, everyone only gets like 1 1/3 as much stuff. That evens everything out across the population: wages go up more slowly than inflation, and spread more stuff among more people by giving everyone a smaller portion of that stuff.

        If we really did keep the buying power of a dollar the same (it’s impossible), your wages would go down over time. Instead, we print more money and create inflation (and the Federal Reserve loans money into existence, so some of the new money comes from the consumer base, who later pay it back with inflated dollars over a loan payment schedule in which their payments get smaller over time). Your salary goes up, but slower than inflation.

        It’s mathematically impossible to do it any other way because you’d have more dollars being paid than exist at that given time. If you know you only printed $500 but you take a count and find everyone’s bank accounts contain $1,000, somebody is printing up funny money. As the population scales up, each person needs to receive a smaller proportion of the total amount of money (and stuff) available at any given time.

        It doesn’t take con-men to make this stuff not always even out. A blunt, honest attempt to manage the money supply in the most beneficial way will cause the sort of winners-and-losers system you describe, if for no other reason than because it’s just hard or literally impossible to get it quite right.

        Liked by 1 person

      4. jerhail says:

        Very thorough explanation and very followable. I do have a question about what this means in general but using your example and numbers to apply an example for the general question.

        Is it better to be older or younger in this system? If per your example the value of money is effectively halved but then a each dollar is granted a one-third value while the remaining two-thirds are combined to provide one and one-third value to each person in the population growth, is it better to have you dollar devalued by two-thirds (older person) due to population growth or increased by one-third (younger person) so you don’t have to earn your dollar to the same extent as previous generations?

        It sounds like younger people will always have it better than previous generations though as one generation ages they essentially have the value of their money degraded and yet it will always be more than before.

        The reason I ask is wouldn’t this mean that the best thing to do with money is either find a way to get a higher return than inflation (which is impossible for everyone) or spend it immediately and have steady and reliable permanent income which continues to increase in value at a faster rate than can be saved?

        And doesn’t this mean that because not everyone has steady and reliable permanent income that AT LEAST one person is effectively the victim of inflation because not everyone can get a higher return than inflation and not everyone who is employable is?

        I get that for the majority it might be better but I’m still thinking quite a few people get an unfair deal automatically which in my opinion is not appropriate; though, and to be fair, perhaps I have it wrong and/or ultimately this is why we keep taxes high enough to provide benefits for those pushed out of the system.

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  4. Your articles are detailed. Which is nice 🙂 Also it’s be nice of you to visit my blog and write a friendly comment in return and you shall definitely see me commenting here more often. 🙂 [www.exotickuwait.com]

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  5. Explaining the Keynesian Thoery is never easy ,particularly for a 15 year old.Anyway,you have done a fantastic job here,I see.

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  6. Scottie says:

    Reblogged this on Scotties Toy Box and commented:
    This is a great read. It took me two days to really read it and understand it. The author is very smart, despite his young age, and I respect him. I have always been a follower of the Keynesian economics. If you go back to the beginning years on my blog I use to get into huge comment arguments with a person who was totally a hard wing republican tea party tool. He hated the ideas of Keynes. There was no talking to him, he couldn’t see what was clearly supported by fact. The fact is that if no one can buy products , then no one can sell them, if they can’t sell the products, they can’t have a business, make a profit and hire people. No business means no economic growth. I once heard a wealthy man on Ted talks say that with all his millions and maybe billions, he couldn’t buy enough to equal all the people in the country. He couldn’t buy enough clothes, he couldn’t buy enough cars, and same with food. He said it took people being able to spend, lots of people to be able to have extra money to buy things , that would then create demand to make more, to hire the people to do it, and all the needed infrastructure to get it to the market and stuff. The real job creators are the people who can afford to guy stuff, spend money and get items. Sadly when the wages in our country stagnated and people couldn’t buy what they needed they turned to credit which was a huge honey pot trap. The fact is in bad times when the people can’t afford to spend or buy history has shown that it is up to the government to take over and spend enough to keep business going. Then more people in work means more who can spend. FOr us the bad part is greedy people have become so convinced to starve the wages of the people who work for them they can’t afford to live, in the “richest country in the world”. Yes because employers and the wealthy and greedy politicians together have decided to make all weath for the top only, the mass majority don’t have any buying power. Not able to by hurt the economy. The solution is for those at the top income levels to be less greedy and to give the workers living wages, and more. But I am sure the author of this great blog has a wonderful post in the future to address this issue. I look forward to reading it. Hugs

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    1. Thank you so much for the reblog and the long comment! I’ve already written a post on income inequality BTW 🙂

      Liked by 1 person

      1. Scottie says:

        Shrey you are awesome. I am very impressed by your writing, the research you do, your ability to master the data. These are things people much older than you lack. Keep up the good work. Your future looks very wonderful. I look forward to that post on income inequality. Best wishes. Hugs

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  7. This is always a firebrand debate. Of course there is no absolute right and wrong here, which I think is what Shrey intended. A little of this and a little of that makes a stew. It does seem however that the experiment of the last 8 years has been a complete failure. The banks are bigger; the financial games are more prevalent, and the disparity of wealth is greater. The sophistication of the financial markets may be to blame – combined with the lack of morality in the industry, and maybe society as a whole.

    On a positive note, I do believe that part of the slow down in demand is due to people abandoning the consumerist mentality. Some would argue this is a bad thing – not me.

    Of course economic dynamics are often localized. In other words, while silicon valley is booming right now, North Dakota is reeling from low oil prices. Real estate in San Fransisco is ridiculous and housing in North Dakota is tanking, where just two years ago you couldn’t find a place to rent.

    On a grand scale, worldwide finances are not pretty, but a small population of Wall Street insiders are getting richer by leaps and bounds. This is why Donald Trump and Bernie Sanders are doing so well. And, these two guys may illustrate perfectly the battle of ideas, and the debate of economic methodologies.

    Philosophically, people need to ask themselves:

    What is important to you?

    Do you want to be really rich?

    What are you willing to do to accomplish this?

    If you answered yes, I want to be really rich, ask yourself why?

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  8. Hi, thanks Shrey for commenting on my economics blog. This article is a great interpretation on Keynesian theories. I must admit though, I am a strong believer in the Austrian theories. Have you seen the Keynes and Hayek rap battles by EconStories, as I think they highlight their theories very well? If not here’s the playlist .

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